U.S. stocks will be ‘very disappointing’ for 10 years

Opinion: Equities have been overvalued for some time, six gauges show

U.S. stocks are overvalued — and have been for months. That is what six well-known measures of valuation show.

While that doesn’t mean a bear market is imminent, there is a high probability that investment returns over the next decade will be below average, according to Yale University economics professor and Nobel laureate Robert Shiller.

Investors shouldn’t expect that what has worked for them over the past five years will continue to work in the future.

One way to gauge the market’s valuation is to compare it to past bull-market peaks. There have been 35 since 1900, according to Ned Davis Research, a quantitative-research firm.

Five of these six valuation ratios show the market is more overvalued today than it was at between 82% and 89% of those peaks. They are:

* The cyclically adjusted price/earnings ratio championed by Shiller, calculated by dividing the S&P 500 by its average inflation-adjusted earnings per share over the past decade.

* The dividend yield, which is the percentage of a company’s stock price represented by its total annual dividends.

* The price/sales ratio, calculated by dividing a company’s stock price by its per-share sales.

* The price/book ratio, calculated by dividing a company’s stock price by its per-share book value, an accounting measure of net worth.

* The Q ratio, calculated by dividing a company’s market capitalization by the replacement cost of its assets.

It is noteworthy that there is such agreement among these ratios even though each calculates the market’s valuation in a profoundly different way.

The sixth data point — the traditional price/earnings ratio, which focuses on trailing or projected 12-month earnings — is the one that paints the least-bearish picture. Still, it shows the market to be more overvalued than it was at 69% of those past market peaks.

Shiller argues that the P/E doesn’t have as good a forecasting record as his cyclically adjusted variant.

Some investors are ignoring the warning signs from these valuation ratios, since the bull market has continued higher even though the measures have told much the same story for some time.

Yet Shiller says that it is “hardly surprising” that the market has gone up over the past year despite an above-average cyclically adjusted price/earnings ratio, since his research always has shown that it and other valuation ratios have poor forecasting power over periods as short as a year. It is his ratio’s ability to forecast 10-year returns that he finds noteworthy.

He points out that it was in December 1996 that he gave his now-famous talk to the Federal Reserve that led Alan Greenspan, then the Fed’s chairman, to warn of “irrational exuberance.” The market continued to do well for three more years before succumbing in early 2000.

Ben Inker, co-head of the asset-allocation team at Boston-based money management firm GMO, which has $119 billion in assets, likens the market to a leaf in a hurricane.

“You have no idea where the leaf will be a minute or an hour from now,” he says. “But eventually gravity will win out and it will land on the ground.”

The chief point of all this for investors? Simply this: The stock market isn’t poised to produce returns that are in line with even its long-term annualized average of around 10%, much less the 20%-plus returns we have seen over the past five years.

“I can say with high confidence that investors are going to get very disappointing returns from U.S. stocks over the coming 10 years,” says Rob Arnott, chairman of Research Affiliates, an asset-management firm in Newport Beach, Calif., that advises on $178 billion in investment strategies.

Unfortunately, none of the valuation ratios help us determine the path the market will take in producing these anemic returns. It could turn in low but positive returns during the next 10 years, or it could soar first and then plummet, as it did in the late 1990s and early 2000s.

One way to increase the odds of getting better long-term results may be to invest in foreign equities, though, as amply illustrated by the turmoil in European markets this past week, they can also be much riskier than the U.S. market and may not be appropriate for everyone.

Mebane Faber, chief investment officer at Cambria Investment Management in El Segundo, Calif., with $400 million in assets, says that the cyclically adjusted price/earnings ratio is higher in the U.S. than in 52 of 54 foreign stock markets. Among the countries with the lowest such ratios right now, he says, are Argentina, Greece and Russia.

For a more-diversified, and less risky, bet on world-wide emerging markets, consider the Vanguard FTSE Emerging Markets ETF
VWO, -0.37%
with a 0.15% expense ratio.

You also might consider U.S. consumer-discretionary and consumer-staples stocks, which Ned Davis Research has found have performed the best in the final stages of past bull markets. Two ETFs benchmarked to those sectors are the Select Sector SPDR-Consumer Discretionary
XLY, -0.48%
and the Select Sector SPDR-Consumer Staples
XLP, +0.40%
both of which charge annual fees of 0.16%.

The most popular stocks in these two sectors among the advisers tracked by the Hulbert Financial Digest who have beaten the stock market over the past 15 years are cable company Comcast
CMCSA, -0.72%
; entertainment giant Walt Disney
DIS, +1.28%
; fast-food chain McDonald’s
MCD, -1.86%
; PepsiCo
PEP, +0.08%
the beverage company; and two consumer-products companies, Kimberly-Clark
KMB, +0.24%
and Procter & Gamble
PG, +0.23%

Mark Hulbert is editor of the Hulbert Financial Digest, which is owned by MarketWatch/Dow Jones. Email: mark.hulbert@dowjones.com

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